Two readily accessible data series suggest something else is brewing in the high-yield market.
My colleague Cinthia Murphy recently pointed out—in the piece “Investors Losing Love For Junk Bond ETFs”—that U.S. corporate high-yield ETFs have been under heavy pressure recently. Some of the most prominent high yield ETFs experienced massive redemption and losses in July:
- iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-69) experienced $1.7 billion in outflows
- SPDR Barclays High Yield Bond ETF (JNK | B-66) experienced $745 million in outflows
- Pimco 0-5 Year High Yield Corporate Bond ETF (HYS | B-86) experienced $523 million in outflows
These asset losses came as the performance of these funds also took a nose dive, as the chart below shows. For comparison’s sake, I’m plotting HYG, JNK and HYS against the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-75) to show the year-to-date performance of the U.S. corporate investment-grade segment versus high yield.
What the chart tells us that the sell-off seems to be isolated in the high-yield space rather than a broader corporate credit phenomenon. Indeed, LQD’s performance fared relatively well despite a $472 million net outflow in July.
It seems investors were rotating out of the risky part of the fixed-income market because they either thought they were not being compensated adequately for the risk—and there are better options elsewhere—or they believed corporate credit quality is deteriorating and default rates are going to spike.
The question we are faced with is, Was the sell-off just a pullback, and an opportunity to get in the junk bond space, or a reversal of broader market sentiment?
Looking at the options-adjusted spreads (OAS) and credit default swap (CDS) spreads, I am inclined to believe there may be something more than a pullback brewing underneath this market.
For OAS, I am looking at the Bank of America Merrill Lynch US High Yield Master II OAS (HY OAS). For CDS spreads, I am using S&P/ISDA CDS U.S. High-Yield Index (CDS).
High-yield bonds, also known as junk bonds, are bonds that one or more rating agencies (S&P, Moody’s and Fitch) has rated as below investment grade based on probability of default.
These bonds, in the most simplistic terms, are priced off of risk-free assets of similar maturity characteristics. Treasury yields are often used as the risk-free rate for pricing. Beyond that, junk bond investors demand additional compensation based on credit risk, also known as the credit spread.
Some bonds may also have embedded option features that also affect their interest rate sensitivities and values.
Adding it all up, the OAS is a popular metric that an investor can look at to see how well he/she is being compensated for the additional credit risk. In other words, OAS is a good reflection of credit risk.
While not tracked by any existing ETF, the Bank of America Merrill Lynch US High Yield Master II OAS provides a pretty good overview on the historical trend of U.S. corporate high-yield bond OAS. (Data is available via St. Louis Federal Reserve Economic Data (FRED).)
A quick glance at the historical OAS quickly shows that current OAS is below both historical average and median but not quite there yet with respect to historical low. Will the reversion to the mean occur, or a resumption of further OAS compression? Let’s look at another data series for possible hints.
The S&P/ISDA CDS U.S. High-Yield Index measures the average spreads (prices) that one will have to pay to buy protection against 80 equally weighted reference U.S. entities. (Three-year index data is available for free via S&P Dow Jones Indices.)
The index is quoted in basis points. That means the higher the index, the more costly it is to purchase default protection against the underlying entities collectively. It is a rough gauge of the market’s appetite for credit risk, or anxiety over default risk.
The chart below plots both the CDS index against the high-yield OAS series to see if there is any correlation between market’s sentiment on default risk and OAS.
As one can quickly see, high-yield OAS is practically moving in lock step with CDS spreads.
Looking at July onward, there seems to have been a real turning point for the high-yield market, as there was a meaningful uptick on CDS spreads. That means that either there was an increase in fears of default risk or a reduction in appetite for credit risk. OAS spiked during the same period too.
When put together, the upticks in CDS spreads and high-yield OAS lead me to believe that something else is brewing in the high-yield space. The sell-off is more than a pullback. Investors are either nervous about default risk or don’t have much appetite for further credit risk at this point.
Either way, they demand higher compensation in the form of OAS for taking on additional credit risk.
While these two benchmarks are far from conclusive, or all-encompassing, they are readily available indicators of what’s going on in the bond market, and offer investors of all sizes—and expertise—a good barometer for the market’s risk appetite.
At the time this article was written, the author held no positions in securities mentioned above. Contact Howard Lee at [email protected].